I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

As you may have heard, super-rich guy Warren Buffett recently penned an op-ed piece in the New York Times calling for higher taxes on super-rich guys. Buffett’s arguments have been covered in detail (see inset article from Forbes’ Abram Brown) so I won’t belabor Buffett’s positions, but I would like to address the following, which may have been disregarded as a throwaway paragraph in Buffett’s piece.

Above all, we should not postpone these changes in the name of “reforming” the tax code. True, changes are badly needed. We need to get rid of arrangements like “carried interest” that enable income from labor to be magically converted into capital gains.

The carried interest debate has been a hot button for tax geeks for several years, but thanks to this year’s election — or to be more precise, the uproar surrounding Mitt Romney’s 13% effective tax rates in 2010 and 2011, which were largely attributable to the carried interest tax break — the concept has gone mainstream. And as evidenced by the calls for tax reform that have recently emanated from Buffett and high-ranking members of both political parties, this debate is only going to grow more relevant and far more heated. As a result, there exists the realistic possibility that at some point in the near future, you may find yourself in a conversation that has taken an unfortunate turn, with you being asked for your thoughts on what to do about this “carried interest loophole that allows already-rich private equity fund managers to pay a 15% tax rate on their income.”

So you’ve got to be prepared. Because let’s be honest; dinner party conversations are nothing more than thinly-veiled battles for intellectual superiority, and nobody wants to play the role of the under-educated. So why not avoid future embarassment, check out this handy Carried Interest Q&A, and finally one-up Erica’s know-it-all husband Steve.

Q: Oh, how I hate that Steve…he thinks he’s the Pope of Chilitown. Tell me everything I need to know. What is a “carried interest,” anyway?

A: In general terms, a carried interest can refer to any interest a person receives in the future profits of a partnership in exchange for services rendered. But in political parlance, the term “carried interest” has come to mean a particular type of profits interest; specifically, the one routinely received by private equity or hedge fund managers.

Q: I’ve heard of private equity funds. Didn’t the money man who ran for president manage one of those?

A: You’re referring to Mitt Romney, and yes, he did.

A private equity fund is a business — typically structured as a limited partnership — that takes the pooled capital of a small group of institutional investors or wealthy individuals and invests the funds in various stock holdings. Upon formation, an individual (or several individuals) will be hired to manage the fund. In addition to being compensated with a management fee (typically equal to 2% of the assets being managed), it is common practice for fund managers to receive a right to 20% of the future profits of the fund in exchange for choosing and managing the investments. It is this profits interest that is commonly referred to as “carried interest.”

Example: Dusty, Lucky, and Ned wish to form a private equity fund. Ned has significant expertise in choosing investments that Dusty and Lucky would like to profit from. The three individuals form an LLC, with Dusty and Lucky each contributing $100,000 for a 50% capital interest in the LLC. In exchange for managing the fund, Ned is given a 20% interest in the future profits, which may or may not materialize. Ned’s 20% interest in future profits is a “carried interest.” Notice that Ned has no capital account upon formation.

Q: So a fund manager doesn’t have to shell out any cash for a carried interest?

A: Correct. The fund manager will have no obligation to contribute to the capital of the fund in exchange for the profits interest. They will, however, often contribute cash to the fund in exchange for a separate capital interest just to have a larger stake in the fund.

Q: OK, so what’s the big deal? Where is the tax benefit coming from?

A: The tax benefit associated with carried interests — or any pure profits interest for that matter — is the result of two different areas of tax law.

First, under current law, upon formation of the fund and the receipt of the profits interest, the fund manager recognizes no taxable income, even though the profits interest is being granted in exchange for future services. This is where partnership law currently deviates from the law governing corporations.

Under I.R.C. § 83, if a corporation issues its stock in exchange for future services, the recipient recognizes compensation income upon receipt (assuming the stock is freely transferable and not subject to a substantial risk of forfeiture).

Specific to partnership taxation, however, Revenue Rulings 91-27 and 2001-43 provide that generally, no compensation income is recognized by the recipient of a pure profits partnership interest, because the interest has no liquidation value on the date it is received. In other words, were the fund to hypothetically sell off its assets and liquidate immediately after formation, the owner of a pure profits interest would receive nothing, because there has been no additional appreciation after the partner received the profits interest. Since there is no value, there is no taxable event.

Q: So that’s the first benefit, no tax on Day 1. But where does the 15% rate piece come in?

A: Once the fund manager has his pure profits interest, he is entitled to be allocated (in our example) 20% of the future income generated by the partnership. And what types of income does a private equity fund typically generate? Long term capital gains and “qualified dividends,” which are both subject to the preferential 15% tax rates currently in place.

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